I have a new client who for many years contributed after-tax $$ to his regular (NOT ROTH) 401k plan.
He left his employer in 2012 and at the time had $100,000 in his regular 401k which consisted of $25,000 in after-tax contributions and $75,000 in regular contributions.
When the 401k was rolled over bac in 2012, the pre-tax funds were rolled into a Traditional IRA and the $25,000 (after-tax money) was rolled into a separate Traditional IRA as well.
Fast forward to 2020...the client's advisor wanted to do a Roth conversion, so the topic came up about how the client had contributed to a regular 401k with after-tax money, so he was wondering why he would have to pay tax on the Roth conversion. (My client had originally though that the after-tax money was rolled into a Roth IRA - which it wasn't).
So, the question is, can he do a Roth conversion now with the Traditional IRA that holds the after-tax money as well as the earnings on it for the last 8 years? Or is he basically screwed at this point because he should have acted within 60 days of the rollover back in 2012? Any help would be appreciated.
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"why he would have to pay tax on the Roth conversion."
Every taking or conversion includes the computation of Basis across all Traditional IRA accounts. Of course you can make any conversion you want to. It will all be prorated against total basis and total account(s) balance for the conversion. Only the pre-tax and earnings % is taxable.
For your example, then, 25% of the conversion is not taxable.
Right agreed - will be prorata allocation of the taxable portion of the conversion.
I think my bigger question is...did the broker screw this up back in 2012 when they transferred the after-tax money into a Traditional IRA? Seems like they did. Seems like those funds should have went into a Roth IRA since they were after tax contributions. IRS doesn't know that the funds in the one Traditional IRA were sourced to after-tax money while it was in his 401k. So, I'm not sure what happens now when that Traditional IRA is converted to a Roth? He'll pay tax on after-tax money!?
"did the broker screw this up"
Maybe, maybe not; the broker had to follow the rules that were in place for Employer plan transfers at that time.
"For many years the financial planning and tax community was not sure if after-tax funds in a company plan could legally be rolled into a Roth IRA. In September 2014 an IRS ruling clarified this and the answer is a definitive "Yes." "
from: https://www.thebalance.com/can-i-roll-after-tax-401-k-funds-to-a-roth-ira-2388224
"IRS Notice 2014–54 handed us another tool for building assets in a Roth IRA. The ruling provides a path for rolling over any after-tax money in an employer-sponsored plan, such as 401(k)s and 403(b)s, to a Roth IRA. Employees with after-tax money in these plans can take a complete distribution and direct the plan administrator to send pre-tax dollars to a traditional IRA or another plan and then roll the after-tax contributions into a Roth IRA tax-free."
"IRS doesn't know that the funds in the one Traditional IRA were sourced to after-tax money while it was in his 401k."
That's what form 8606 is used for.
"Non-deductible contributions to an IRA are reported on IRS Form 8606. This informs the IRS that certain funds in the IRA have already been taxed. This is the process used to track this information so the funds do not get taxed again when they are withdrawn. Non-deductible IRA contributions are not the only way after-tax funds end up in an IRA. They can also be rolled over from an employer plan. The IRS recently ruled after-tax money in an employer plan can be rolled directly into a Roth IRA. The taxable amount of a withdrawal from an IRA containing both after-tax and pre-tax funds is determined using the pro-rata rule. This pro-rata calculation is also done on Form 8606."
"when that Traditional IRA is converted to a Roth? He'll pay tax on after-tax money!?"
Only on Non-Basis. That means Not the Post-tax amount.
"Any partial distribution from the plan must include some of the pretax amounts. Notice 2014-54 doesn’t change the requirement that each plan distribution must include a proportional share of the pretax and after-tax amounts in the account."
From: https://www.irs.gov/retirement-plans/rollovers-of-after-tax-contributions-in-retirement-plans
Only the earnings, like this:
Pre-tax contribution <== taxed on conversion or distribution
Post-tax contribution <== not taxed on conversion or distribution
All Earnings <== taxed on conversion or distribution
And it's Pro-rata. You cannot declare the $25k is Post-tax, in your example. It's all in the same swimming pool. It's 25%, not $25k. Think about how Backdoor Roth works the same way. You don't qualify for Roth, so you put into a Traditional IRA your post-tax amount and immediately convert to Roth. If you have any other Trad IRA that was pre-tax or deferred, it all gets factored in for Pro-rata. Not just the one account, but across all that apply per the IRS formula.
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